Uncommon Valor

A kiss on the hand may be quite continental, but preferred
stocks can be an investor's best friend. If you're not
familiar with this type of security, its characteristics are a
cross between a common stock and a bond. For years, large
institutions were the biggest investors in traditional preferred
stock, although new twists on the old formula of preferreds are
making them more accessible and more interesting to individual
investors.

Like common stock, preferred stock represents ownership in a
corporation. On a company's balance sheet, it appears under the
"equity" section. Unlike common stock, however, preferred
stock may pay a set dividend--similar to bonds that pay a set
interest payment. If a company's assets are liquidated,
preferred stockholders are usually paid before common stockholders,
but after debt holders, making preferred stock more attractive to
safety-conscious investors than common stock (though less secure
than bonds).

Preferred stocks are rated by Moody's and Standard &
Poor to give you a sound basis upon which to judge their quality.
Preferred stocks usually have higher dividends than their common
cousins, making them more attractive to those looking for Mr.
Yieldbar. Yet, as the name suggests, preferred stock is not for
everyone.

On the downside, like any fixed-income security, many preferreds
offer little protection from inflation. If interest rates rise,
though you'll continue to receive fixed payments, your
purchasing power will decrease. Higher interest rates are usually
no fun for fixed-income investments of any kind, especially since
the price of your stock will probably fall as well, adding insult
to injury.

Of course, this scenario isn't a problem if you intend to
hold your position, but should you decide to sell, you may run into
another problem: illiquidity. Preferred stock issues are not as
widely traded as common stock, so there may be a significant spread
between the asking and bid price.

Despite these faults, income-oriented individual investors and
corporations alike still find preferred stock attractive. The
secret is to know what you're doing.

The Five-Year Itch

Unlike bonds, which have a set maturity, most traditional
preferred stocks are perpetual. Having a security that requires
perpetual dividend payments can be a drain on a company, so to
induce investors to surrender their shares, a company may have to
offer to buy them from their shareholders at a higher price--not
always the preferred option.

Enter callable preferreds. Most preferred stocks issued today
have call dates after which the issuer can "call," or
redeem, the shares at a predetermined price. Here's how it
works: Investors who buy a new issue of preferred stocks often have
call protection for five years. That means the company can't
call their stock during this period, but any time afterward the
shares are fair game.

Many preferreds are called either at the issuing price or at a
slight premium. This potential bonus is a boon for investors, too.
Some companies also issue convertible preferreds that
convert into a set amount of underlying common stock--at the
company's convenience, of course.

The Misfits

Part of the beauty of preferred stock is its predictability--a
set dividend, a perpetual life span, set payment dates.
Unfortunately, it's the privilege of some preferred stocks to
change their minds. In addition to standard, callable and
convertible preferred stocks, there are adjustable-rate, cushion
and cumulative varieties.

Like any fixed-income investment, preferred stocks are hurt by
rising interest rates. To counteract the effects of inflation,
consider adjustable-rate preferreds.

Here's an example of how they work: XYZ Co. series N
preferred stock adjusts its dividend each quarter based on 85
percent of the highest yields of the 3-month, 10-month or 30-year
Treasury bond. Let's say the 30-year Treasury has the highest
yield of 7 percent to maturity. Multiply this rate by 85 percent to
reset the adjustable-rate preferred's dividend to an annual
rate of 5.95 percent (7 percent [infinity] 0.085 = 5.95 percent).
If the preferred stock has a $25-per-share par (or issue) price,
the dividend paid is $1.48 ($25 [infinity] .0595 = $1.48). This
rate is in effect for one quarter, then the process is repeated.
Almost all adjustable-rate preferreds have a "collar," or
a minimum and maximum interest rate to which the dividend can be
reset.

Should you need a more reliable dividend, cushion preferred
stock could provide just the kicker you're looking for. The
idea here is to purchase the higher coupon issues that have a
greater likelihood of being called by the issuer. By purchasing
higher coupon issues, you can collect a larger dividend payment. At
the same time, there is a higher chance that your securities will
be called, allowing you to reinvest the proceeds in potentially
higher-yielding securities that may be available.

Dividends on preferred stocks are paid from a company's
earnings. No earnings, no dividend. What's a preferred investor
to do? Before you invest, ask your financial advisor whether the
stock is cumulative preferred. If the company should run into
difficulties, cumulative preferred stock must pay its shareholders
all owed interest before it can resume its dividend payments on
common shares.

Some Like It Monthly

Both common and preferred stock traditionally pay dividends
quarterly. Income-oriented investors who need monthly payments can
buy an assortment of issues that allow them to receive payments as
needed. If you buy an issue that pays in January, April, July and
September; another that pays in February, May, August and November;
and yet another paying in March, June, October and December, all
months are covered.

Some investors shy away from this idea because it seems too
complicated. For them, several newer types of preferred securities
may be just the ticket.

Monthly Income Preferred Securities (MIPS) represent a
limited partnership interest in a company that exists solely for
the purpose of issuing preferred securities and lending the
proceeds of the sales to its parent company. In general, MIPS have
the following characteristics: a $25 par value, New York Stock
Exchange (NYSE) listing and cumulative monthly distributions; in
addition, they are noncallable for at least five years, and provide
the issuer with the option of temporarily deferring distribution
payments.

For U.S. taxpayers, MIPS are considered limited partnerships,
and monthly payments are considered partnership distributions.
Investors will receive K-1 forms at year-end in place of 1099s. If
the partnership suspends distributions, it may still allocate those
amounts to investors, who will be liable to pay taxes on the income
allocated but not yet received.

Quarterly Income Preferred Securities (QUIPS) are much
the same as MIPS, but with quarterly payments.

Trust Originated Preferred Securities (TOPRS) are very
similar to MIPS and QUIPS. A TOPRS is a special-purpose business
trust that exists solely to issue preferred securities and then
lend the sales proceeds to the parent company. TOPRS differ in the
area of taxation: Holders will receive 1099-OIDs, unlike QUIPS and
MIPS holders, who receive K-1s.

Quarterly Income Debt Securities (QUIDS) and Monthly
Income Debt Securities (MIDS), two new types of preferred
securities, consist of subordinated debentures, which have 30- to
50-year stated maturities. These debt securities feature a $25 par
value, NYSE listing, quarterly or monthly interest payments, are
noncallable for at least five years, and, like MIPS, QUIPS and
TOPRS, provide the issuer with the option of temporarily deferring
interest payments. Holders of QUIDS and MIDS receive 1099-OIDs at
year-end.

If these securities seem less than easy to understand, they are.
If you're counting on income payments, before you decide to
take advantage of the excellent yields offered by these securities,
remember that temporary suspension of the dividend could put a
crimp in your income flow. Also, this may result in a tax liability
for income allocated but not yet received. Partnership income
reportable on a K-1 form could mean extra work at tax time, too. Be
sure to talk to a tax or legal advisor before you proceed.

Lorayne Fiorillo is first vice president of investments at
Prudential Securities. She presents retirement planning and
personal finance workshops worldwide. For more information, write
to her in care of Entrepreneur, 2392 Morse Ave., Irvine, CA
92614.

The Bus Stops Here

Large corporations such as insurance companies and banks have
long been fans of preferred stock. The primary reason it is so
attractive to institutional investors is that 70 percent of the
dividends received from preferred stock are exempt from federal
taxes. (Newer types of preferred securities are not eligible for
this deduction, however, so consult your tax advisor.) These tax
benefits aren't limited to giant corporations, either. Any C
corporation can qualify. Ask your tax and financial advisors how
you can apply this benefit to your corporate account.

Whether in cumulative, adjustable, monthly or quarterly
versions, you can select preferred stocks to fit your form. Yes,
preferreds can be an income-oriented investor's best
friend.